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NxStage Medical Inc. (NASDAQ:NXTM)

Q3 2008 Earnings Call

November 3, 2008 9:00 am ET

Executives

Kristen Sheppard – Vice President of Investor Relations

Jeffrey H. Burbank – Chief Executive Officer, President

Robert S. Brown – Chief Financial Officer

Analysts

Taylor Harris – JP Morgan

Benjamin Andrew – William Blair & Company

Philip Legendy – Thomas Weisel Partners

William Plovanic – Canaccord Adams

Operator

(Operator Instructions) I would now like to turn the presentation over to your host for today's call, Ms. Kristen Sheppard.

Kristen Sheppard

Welcome to NxStage Medical third quarter 2008 financial results conference call. My name is Kristen Sheppard, Vice President of Investor Relations. With me here today are Jeff Burbank NxStage's CEO, and Robert Brown our CFO.

A replay of this call will be available shortly after the conclusion for two weeks. In addition, the press release for the third quarter and recording of this call will be archived on our website under the investor information section.

Before starting I would like to remind you that statements we make on this call which are not purely historical regarding the company's or our intentions, beliefs, expectations and strategies for the future are forward-looking statements for purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995.

These forward-looking statements may include topics such as the results of our operations, growth of the home and more frequent hemodialysis market in general, marketed option and demand for our product, the rollout of the PureFlow SL, anticipated benefits of the Medisystems acquisition, anticipated improvements in the operating efficiencies, gross margins, product quality and financial guidance for the future.

Because such statements deal with future events, they are subject to various risks and uncertainties and actual results may differ materially from these forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements are discussed in our SEC filings including our quarterly report on Form 10Q for the period ended June 30, 2008.

In addition, any forward-looking statements made on this call represents company's views only as of today and should not be relied upon as representing our views as of subsequent dates. Future events and developments may cause these expectations to change and while we may elect to update forward-looking statements at some point in the future, the company disclaims any obligation to do so and therefore you should not rely on these forward-looking statements as representing our views on any date subsequent to today.

Now I'd like to turn this call over to Jeff.

Jeffrey H. Burbank

I’ll begin with an update on the business and provide some comments around our outlook for Q4. After my comments Robert will discuss the financials and our guidance for the fourth quarter then we'll open the call to your questions.

I'm please to report that we continue to make measurable progress on both our financial and operational objectives during Q3. The quarter played out within our expectations. Third quarter revenues were within guidance at $30.5 million. That's up 163% compared to third quarter of 2007.

On a sequential basis, Q3 revenue declined approximately $1 million which was within our projections. Just as we had predicted on our last call this drop was due to our primary in-center distributor bringing down inventory levels, but also as expected end customer sales in the in-center market were strong.

I'm also please to report that our home and critical care businesses continue to perform well. Importantly, even at this revenue level we improved gross margins two points when compared to the second quarter to 16%. This reflects our progress on key initiatives to drive down cost to goods sold and leverage new efficiencies.

We reported a net loss of $15 million which included a $1.8 million loss associated with the accounting treatment for the private placement we closed in Q3. Excluding this accounting our net loss was $13.1 million at the better end of our expected range and importantly 11% improvement from Q2. We also narrowed our adjusted EBITDA loss to $7.3 million and reduced cash burn by 22%.

I think you can all begin to see how our focus on sustainable growth is beginning to pay off. Our team is in place and I believe we have the road map to get to break even and profitability. With no major investments required and based on our projections we don’t need to raise cash.

For these reasons and more we continue to believe that we have the required resources to fund our currently projected operating requirements. Robert will review these in detail to you in a few minutes.

Now, let me provide some color on each of the three businesses. Let's start with the home market. We have two significant milestones in this market that I want to highlight. First, I'm pleased to announce that we recently achieved 3,000 end-stage renal disease patients prescribed to receive therapy using the System One.

That's representing a 35% increase over the number of patients at the end of 2007. With this milestone NxStage has nearly tripled the number of patients on home hemodialysis since 2006. This systematic progress of increasing the number of patients on home or at home using NxStage System One is important evidence that this market is going to expand.

Our second milestone is the upcoming presentation of the interim four-month Quality of Life data from our FREEDOM study. This is the first report of any findings from the FREEDOM study and it's truly gratifying to be able to make such positive data public. At only four months our interim results are positive and statistically significant. We continue to be very optimistic about our FREEDOM study results and the positive impact it can have.

These milestones are exciting and significant for our business but just as important is the steady progress we continue to make against a number of strategic initiatives intended to build momentum and strengthen our position in the home market.

In the past three quarters I've talked about four central growth initiatives, going deep, clinical data, product, and reimbursement. These initiatives produced tangible results during Q3 and we remain confident that continued execution against these represents a pathway to profitability and growth for NxStage which benefit all our stakeholders.

First, our go-deep strategy. As a reminder, this is a strategy focused on building scale at existing centers to create sustainable programs with strong infrastructure. We believe that the cooperative efforts between NxStage and our partners are leading to improved access and retention which benefits both providers and patients.

For example, we grew the number of centers with greater than 10 patients to 76 in the third quarter, which is a 13% increase just over the second quarter and a 61% increase over the third quarter of 2007. We also increased the number of patients trained within our centers by 24% in aggregate when compared to the third quarter of 2007.

We see real benefits in going deep and so do our customers as demonstrated by the fact that 30% or 40% of our patients actually changed centers to access NxStage's therapy. In addition, our retention rate continues to trend favorably. As we think about continuing to build demand within our centers we believe the results of recent localized patient-to-patient efforts show that we have the right focus.

As an example, one of our patients recently took a summer to travel across the country with his grandsons in an RV. It's great to see our patients able to travel like this, but what was even more impressive was that this patient was so motivated by his own prospective and experience with NxStage home daily therapy that he visited 20 dialysis centers along the way taking time to talk to in-center patients about home daily dialysis on NxStage. Often he even dialyzed in front of them.

We posted a clip of Harvey's tour on our website and also he posted it on YouTube. You ought to really take a look at this. It is amazing the impact patient word-of-mouth can have. Harvey's tour and the accompanying center open houses made at least 80 patients and their families think more about home daily hemodialysis.

As of the close of the third quarter, we had a number of these patients begin treatment on the NxStage System One. This is encouraging evidence that increased patient awareness is the process and the benefits of home daily hemodialysis can make this market grow. We’re extremely grateful to patients like Harvey who share in our passion and dedication to improve access to this important therapy.

Next, clinical data. We also continue to build upon the growing body of clinical data in support of further adoption of daily therapy. Last quarter we released data showing that 50% reduction in mortality for patients on our therapy. This analysis was based on over 2,000 patients in the NxStage patient registry that have done home daily dialysis on the NxStage System One.

Today, we are pleased to share the interim four-month Quality of Life data from our FREEDOM study. These findings will be followed by the 12-month Quality of Life data and additional results in the future. FREEDOM is the first and largest trial to measure the clinical and economic benefits of daily home hemodialysis as compared to conventional three times a week in-center treatments.

Research will present these interim findings this Friday, November 7 during the American Society of Nephrology meeting in Philadelphia. Specific highlights include findings that patients receiving daily home hemodialysis with NxStage System One recover faster, had less depressive symptoms, had significant improvement in physical and mental health, and a significant improvement in quality of life. I don't want to steal the thunder of the ASN presentation, but I do want to spend a little more time on one of these findings because I really feel it captures such an important aspect to the benefit of NxStage.

What people are telling us is that it takes about eight hours to recover from an in-center dialysis treatment. So, basically, between traveling back and forth to the clinic, doing your in-center treatment, and recovering from it, a whole day is lost three times a week. When doing frequent NxStage home hemodialysis, our patients are telling us that it takes them about one hour after treatment until they can go about their normal activities and obviously there isn't any traveling time.

It's no wonder patients have coined the phrase that three times a week in-center dialysis is like living to dialyze. For our patients that want to live life, there's no question that NxStage System One can give more time to go about living their life. We're proud of this and our other clinical programs and are committed to ongoing research to continue to meet the needs of the community.

As of today, we now have over 231 patients enrolled in the FREEDOM Study. We plan to report the 12-month Quality of Life interim analysis at the American Dialysis Conference the end of February in 2009, obviously, and additional data looking at the economics in mid to late 2009.

This leads to our third strategy, reimbursement.

We believe that the combination of all this data, the potential to live a better longer life creates a strong platform for communicating the clinical and economic value of daily home hemodialysis to patients, providers and payers, namely Medicare. Medicare's spending totaled $355 billion in 2006. ESRD represents $23 billion or 6.5% of this spend.

Home patients cost the system over 25% less per year, due to lower hospital and drug costs and CMS's data has consistently shown this. Medicare data shows in-center hemodialysis patients cost approximately $72,000 per patient per year, while home patients cost only $53,000 per patient per year. Medicare spends more on the hospital and drugs than it does on dialysis.

Daily home hemodialysis can address the key issues that lead to hospitalizations like fluid overload, cardiovascular issues and infections, and studies support this. In addition, daily home patients will use less of those expensive IV drugs. In fact, Kaiser Permanente recently stated and I quote, "Our internal data here at Kaiser found that the total patient care costs were lowest for home hemodialysis patients."

We're leveraging all our clinical data to influence the way providers and payers measure and benchmark effective dialysis treatment with a goal of increasing access and getting more predictable coverage for home daily therapy. The new ESRD conditions for coverage require that all patients be presented home dialysis options and its extremely positive step. We will continue to work to make further advances like this.

Our fourth growth initiative is focused on product. While we don't disclose our product pipeline for competitive reasons, we continue to focus on things that are most important to our patients and providers. As you may have seen, we recently received a 510k clearance for our latest innovations and refinements to the PureFlow SL.

These enhancements include new software and hardware features to further improve ease of testing and maintenance, improve the user interface clarity, features to extend pack life and more automatic problem resolution. All in all, it should make the product easier to use and more reliable.

We also continue to pursue new indications for existing products, including the potential for 510k clearance for a nocturnal home indication by the end of 2009. As we think about our home business for Q4, we remain confident about our growth opportunities.

Simply put, we believe home hemodialysis is a significant market and we are the only company with the most comprehensive solution and the most documented outcomes for delivering clinical and quality-of-life benefits, while reducing costs. We'll continue executing on all four focus areas and drive meaningful results quarter-over quarter.

Turning to our critical care business, during Q3 we continued to do well and compete favorably against Gambro, both in terms of machine placement and machine utilization.

While we're seeing many critical care customers perceive business as usual with respect to machine sales, we cannot ignore the possibility that the tightening credit markets may cause certain hospitals to delay capital equipment purchases or seek alternative financing options in the near-term.

We remain confident on our prospects within this market and believe we are well positioned. Our value proposition of enhancing quality of care, lowering costs, and reducing the burden on critical care staff is increasingly relevant to our customers. As the current economic conditions may limit our ability to accurately predict hospital equipment revenues, we're incorporating a broader range of possible outcomes from flattop for the critical care business in Q4.

Turning to our Medisystems business, last quarter we told you that in-center revenues would decline sequentially as we expected sales to distributors to decrease as a result of our largest distributor lowering blood tubing inventory levels. The third quarter played out just as anticipated. End-user demand remained strong in Q3 and sales to distributors declined $1.7 million from Q2, accounting for the entire in-center revenue decline.

In early September, we also successfully negotiated a one-year extension to our blood-tubing contract with DaVita within our expectations. With the DaVita blood tubing set contract now in place, we expect sales to distributors to increase from Q3 to a level more consistent with end-user demand, which remains strong.

However, we expect distributors to continue to manage their inventory tighter and that they are not likely to return to historical inventory levels that we had expected during Q4. This change in inventory management within our largest distributor has led us to align our expectations for our in-center business in Q4, aligned with end customer demand rather than including additional inventory billed over the quarter. The market fundamentals in end-user demand remain strong.

We continue to be optimistic about our in-center business and are pleased with the recent uptick in both interest and activity with value added product offerings, like Streamline, our airless blood tubing set. Streamline has exceeded its one million-treatment mark as a next generation product capable of delivering improved clinical and economic performance to centers; Streamline is strategic to our growth plans.

It's proven value proposition and competitive strength gives us confidence that Streamline will lead to our ability to upgrade or convert our existing customers, as well as opportunities with new accounts. We recently announced that Streamline blood tubing set supply agreement with RAI. RAI is the fourth largest dialysis services provider in the US. In addition, a number of our large partners are currently evaluating Streamline for adoption in their centers.

Overall, we performed well in Q3. We accomplished what we set out to achieve for the quarter and in doing so believe we have further established NxStage as a significant player with a portfolio of uniquely positioned products to address the needs of patients and providers. Our business fundamentals remain strong and we expect to continue to benefit from our mix of complementary businesses.

More specifically, we achieved important milestones in all our businesses. In the home, we achieved 3,000 patients and we released the interim Quality of Life data for FREEDOM. In critical care, we continue to demonstrate the competitive strength of our product and value proposition all while Gambro has reentered the market over the last three quarters, and in the in-center business, we're seeing significant account adoption and conversion to Streamline.

Our value proposition is increasingly relevant in the economic environment. We have compelling growth prospects in all three markets. On an ongoing basis, we've been profitable in two of our markets and we've made measurable progress in the third. We maintain a lead on any competition in the home hemodialysis market and we have good financial footing and improving financial metrics.

Now, I'd like to turn the call over to Robert.

Robert S. Brown

I will review revenue for the third quarter of 2008 including details of our two reporting segments, discuss the company's operating performance, balance sheet, and cash flow results, and then finish with a discussion regarding the outlook for the fourth quarter. I will discuss the numbers on both a GAAP and non-GAAP basis. Please refer to the reconciliation table in our press release for further information in this regard.

Third quarter revenues were $30.5 million within our guidance of $30 to $32 million. The in-center segment had revenues of $13.7 million, an 11% decrease from Q2’s level. This decline was in line with our expectations going into the quarter and is the result of our largest distributor reducing inventory level despite strong end user demand.

The System One segment, which consists of our home and critical care businesses, had revenues of $16.8 million a 4% increase when compared with Q2 and a 45% increase when compared with Q3 of 2007. As Jeff mentioned we continue to see solid growth in the home business.

Q3’s net loss was $15 million or $0.33 per share. The Q3 net loss includes a $1.8 million non-cash loss which reflects the change in value of the financial instrument associated with the recently completed $43 million private placement, which included both common stock and warrants.

As you may recall, our second quarter net loss included a corresponding $2.1 million non-cash gain. Excluding these items we would have narrowed our third quarter net loss by $1.5 million when compared with the second quarter.

As you know, these warrants have the potential to be re-priced based on our ability to achieve patient numbers [inaudible] to receive therapy at or above 3,100 by yearend. We recently achieved 3,000 patients and continue to make progress to get above this number by the end of 2008.

As a result of our progress in reducing cost of good sold, we improved overall gross margins by two points reaching 16% in Q3 compared with 14% in Q2 and a negative 30% in Q3 2007. This is particularly encouraging given that we achieved this on sequentially lower total revenue.

On a non-GAAP basis our adjusted EBITDA loss adjusted for stock base competition, deferred revenue recognized and the liability accounting on the private placement that I just mentioned was $7.3 million. We continue to believe the best way to evaluate NxStage's performance in reducing cash burn is to look at our adjusted EBITDA figure. This is also good indication of the progress we are making against our goal of achieving profitability.

We continue to have good visibility on our projects to drive gross margins. Our efforts to make further improvements in gross margins and lower distribution costs for the System One segment remain on track. Consistent with our plans the System One is now fully manufactured in our Mexico facility and we no longer purchase any material PureFlow hardware from outside contract manufacturers.

We expect to realize the benefit of these and other actions throughout the next few years. As of Q3, System One distribution expenses were 18% of System One revenue compared to our yearend target of 20%.

Turning to the balance sheet and cash flow statement, cash, cash equivalents and marketable securities at September 30, 2008 totaled $32.9 million. Cash used in the third quarter was $11.4 million a 22% reduction from Q2’s level. Included in the third quarter’s cash usage is $7.3 million in adjusted EBITDA, $1 million in interest and $3.1 million for capital expenditures and changes in working capital, which primarily consisted of payment for machines purchased in the second quarter as a result of closing out our equipment manufacturing agreement.

We continue to believe based on current projections that the company has the required resources to fund projected operating requirements, which assumes that we restructured a repayment schedule on the current GE credit facility. We believe we can complete this restructuring before the end of 2009.

From a financial and operating perspective, we remain focused on driving continued quarter-on-quarter improvements in four key areas, revenue, gross margin, adjusted EBITDA, and cash all with the goal of achieving break even in profitability. We made solid progress in these areas in the third quarter.

In sum for Q3, we achieved revenues within our guidance, improved margin by two points to 16%, narrowed our adjusted EBITDA loss by 5%, and reduced our cash burn by 22%. We have much work to accomplish but we remain confident that our strategy is the right one to achieve profitability.

Turning to our guidance for the fourth quarter, as we expect to see continued growth across our three businesses for Q4, we are projecting revenues to be in the range of $32 to $35 million for the fourth quarter. This is a broader than normal range of estimates reflecting lower than expected distributor inventory restocking for our in-center business and the potential impact of tightened hospital capital budgets on the timing of equipment sales within our critical care business.

We expect a net loss in the range of $12.5 to $13.5 million or $0.27 to $0.29 per share, excluding any accounting impact to the private equity financing and an adjusted EBITDA loss in the range of $6.5 to $7.5 million for the fourth quarter 2008. We are making our gross margin target of 18% to 21%.

For the full fiscal year 2008, we are revising our revenue guidance to reflect the current fourth quarter revenue outlook. We expect revenue in the range of $125 to $128 million. We continue to believe that results will fall within our earlier guidance ranges for net loss of $52 to $56 million excluding any accounting impact over the private equity financing and for adjusted EBITDA loss of $28 to $31 million for the full fiscal year of 2008. We continue to make progress to get into our yearend range of 3,100 to 3,500 patients.

Now I would like to open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Philip Legendy – Thomas Weisel Partners.

Philip Legendy – Thomas Weisel Partners

Wondered if you would comment, first a bigger picture question, you’ve said in past quarters that you had key customers who were honing their strategy for opening new home hemo clinics. I wonder if you would give us an update on how those expansions are going.

Robert S. Brown

Yes, most of our efforts are focused on going deep and making sure we’re building centers and programs that have the ability to grow and have sustainability. So, we do continue to add centers but not nearly at the ranges that we had experienced in the past because it’s just not consistent with how we see best to grow the business.

Philip Legendy – Thomas Weisel Partners

In terms of how one of the big customers is DaVita and I believe they were one of the ones who was going through this strategic evaluation. In terms of how they’re controlling how they add new patients, maybe not just new centers. Have we seen any change in their behavior there during the quarter or are they still sort of adding at a measured pace?

Robert S. Brown

I think DaVita is investing a lot in this business. They committed a lot of resources and a significant spend to growing the business, so they are working hard against it. As we move forward we see a huge upside opportunity because we’re just scratching the surface in the potential patient population. We really haven’t seen that materialize yet. So, we’re pleased with the progress we’ve made, but see just a lot of opportunity as we move forward.

Philip Legendy – Thomas Weisel Partners

I just wanted to drill down on a comment in the prepared remarks about the potential for hospital capital budgets to be tightening. Just wondering how are you and if you are actually seeing that dynamic going on in the market? In other words, are you seeing it and how are hospitals communicating to you that they may be trimming back next year?

Robert S. Brown

I don’t think we’re seeing anything different than anybody else is and we’re trying to be a little cautious. Hospital equipment purchases are usually back loaded to the quarters, so it’s hard to get real good visibility when you’re sitting at this point in the quarter. We expect that it could happen in terms of either moving them to different structures.

We offer a range of structures for those hospitals, which wouldn’t delay the purchase it might just structure it different, or there may be some delays and I really honestly, we’re watching it closely but we don’t have a lot of facts. We’ll come back to you as we do and we just are being prudent in that at this point. So we opened up the range, we didn’t bring down the range relative to that, we just opened up the range of possibilities associated with what could occur.

Philip Legendy – Thomas Weisel Partners

Just to be clear are you saying that you have, do you feel that you are already seeing an impact or is this more of a concern about the future and you’re just sort of trying to make sure the projections are –

Robert S. Brown

We have already had customers say things like that, but saying things and doing things are two different things. We had a strong October so I felt good about that, but we have had that being mentioned and I don’t know yet whether that’s a negotiation tactic or whether that’s going to actually impact the revenue moving forward. So, we got to watch it carefully, but that’s what drove our opening of the range.

Philip Legendy – Thomas Weisel Partners

One quick technical question, did you hit the 3,000 patient milestone in 3Q or is that kind of as of the date of the press release?

Robert S. Brown

We hit that recently.

Operator

Your next question comes from Taylor Harris – JP Morgan.

Taylor Harris – JP Morgan

I have a similar question to Phil’s just on the inventory de-stocking. Are you actually seeing that yet, or is that just a communication with the wholesaler?

Robert S. Brown

We have pretty good visibility to that, so that one's real. We typically have pretty good visibility at this point in the quarter to the quarter end, so that's real, and I just want to be clear, Taylor, that end customer demand is nice and growing consistent with how we see that business grow. This is just the difference at the distributor inventory levels.

Taylor Harris – JP Morgan

Yes, that was actually my next question, which is what do you think the end customer demand is growing at?

Robert S. Brown

Historically, we've always said about 5%, 6% is the right growth rate. We're at least that and maybe a little bit more this year.

Taylor Harris – JP Morgan

On the PureFlow 510k changes that you talked about, how are you rolling that out to the field?

Robert S. Brown

How would you like me to quantify that? Well, any type of upgrade like that is a strategy that gets developed with individual partners, so RAI or WellBound or DaVita, we all develop strategies that make it most effective and efficient for their operating structure, and then roll it out that way.

Those discussions have been had and it's the ones that had a faster timeline for that rollout are already starting. Did that get to what you were looking for?

Taylor Harris – JP Morgan

Yes, sure. So it's not like it happens immediately, but it sounds as though at some point almost every patient will get the upgrade?

Robert S. Brown

Yes, upgrades usually take a number of quarters to fully penetrate. It's an 80/20. In a couple quarters you have 80% or more and then there's some stragglers for a couple quarters. This one has some value to the patient so we think it may be adopted a little quicker than something that's just for next stage for instance.

Taylor Harris – JP Morgan

On the accounting for the warrants, can you guys just walk through that one more time to make sure everybody understands what you have to do each quarter?

Robert S. Brown

Yes, at the end of each quarter we have to revalue the warrants to their fair market value, so we go through a Black-Scholes calculation based on all the usual parameters, stock price, volatility, run that number and then we have to record those, and then we run that number through other income. So, it was approximately a $2 million gain in Q2 and about a $2 million loss in Q3, so it's really netted out to about $100,000, $200,000 net between the two quarters, but it does go up and down.

We'll be doing that until the end of the year and the reason why we do it is because of the reset provision on the strike price versus the patient numbers and so once we set that at the end of the year then the warrants will become equity and then we won't revalue them going forward.

Taylor Harris – JP Morgan

So, it really doesn't say anything about the likelihood of hitting your patient targets?

Robert S. Brown

No not at all.

Jeffrey H. Burbank

No it has nothing to do with that.

Robert S. Brown

It has nothing to do with that. It's really just the Black-Scholes calculation.

Taylor Harris – JP Morgan

Last question on the liquidity profile, Robert, maybe you could just talk to us about the line in the press release regarding restructuring the repayment schedule with the GE Credit facility, so what exactly are you trying to do on that front?

Robert S. Brown

Yes, right now our repayment schedule starts in February of next year and it amortizes over 28 months. We've talked to GE and have had some preliminary discussions about actually taking that repayment schedule and actually pushing it out a couple of years, so we've started those conversations. As we go through fourth quarter and early first quarter next year, we'll have more conversations with them about that.

Taylor Harris – JP Morgan

Isn't there a separate borrowing facility within that credit agreement that you have not tapped yet, or am I mistaken?

Robert S. Brown

Yes, we have a $20 million revolver which we haven't tapped any of that yet.

Taylor Harris – JP Morgan

So, what's the likelihood that you will tap the revolver?

Robert S. Brown

It's there for us to use. We have plans that basically get us to cash flow break even right now based on our projections. The revolver is in those plans and we'll use it as we need it.

Taylor Harris – JP Morgan

So, right now you've got a little over $30 million of cash on the books and you're burning at it sounds like about $11 million this quarter, but that's going down. So, the different moving parts I guess that we should be contemplating are how much of the revolver do you tap, are you able to push out the payments on the other GE facility, and then just anything beyond that?

Jeffrey H. Burbank

I'll jump in, Taylor, on cash. The reason we try to tie some of these things out for you with revenue progress, gross margin, EBITDA, and then cash is to help you try to bottle this a little bit better. So, the ones you want to focus on are EBITDA, and that continues to make good progress and you've seen our guidance in the fourth quarter which projects it continuing to go down, and we expect that trend to continue. So, adjusted EBITDA will be dropping.

Then you have cash for buying equipment and cash for inventories. As we've stated and we'll say it again today, we're a little rich on equipment because we accelerated some purchases from our vendors to accelerate that transition into our own factory. So, there is some cash tied up in equipment which will come affectively back into the operating business.

So, that affectively adds to our cash, if you will, if I'm being clear. Then adjustments in inventory, and there's a little bit of a requirement for that as we grow the business, but no significant and there's really no significant capital expenditures that we see going forward.

So, those are the pieces and then as you mentioned, we have no reason to believe we can't restructure the payment with GE based on our preliminary discussions there, but we have to go do that for you, and then we have that $20 million revolver that we can tap as well. Hopefully that lays out all the pieces for you a little better.

Taylor Harris – JP Morgan

Yes, it certainly does so that's helpful and it sounds as the break even point is somewhere, if you can push out this facility in your mind you're fine, and if you can't it sounds like you'll just have to find some other solution.

Robert S. Brown

Yes, we've been contacted by other parties. They listen to our calls as well and they have offered us some alternatives that preliminarily we just will start with GE to see how we can do that, but we have been contacted by others that have expressed an interest to talk to us.

Operator

Your next call comes from Benjamin Andrew – William Blair & Company.

Benjamin Andrew – William Blair & Company

First off, Jeff, can you talk about your steps coming away from the presentation of the Quality of Life data? How do you get that out there and how quickly do you think it can move the needle in terms of patient flows?

Jeffrey H. Burbank

I wish I had the perfect crystal ball. We know it's impactful, we know it's meaningful. We really have set it up for a two-step to keep that in people's front lobe here. The first is the presentation at ASN. As many of you know that have been watching us for a while, that and American Dialysis Conference are the two big vehicles for communication to the industry and clinicians. So there's about 8,000 nephrologists that will attend that later this week.

So, we'll be presenting that there, and then all of the collateral marketing efforts that go along with that with our sales force. We'll have another step up at the plate at ADC, which is the end of February where we'll be presenting the 12-month Quality of Life information, so that will solidify that. Obviously, we continue to see positive results there but we'll be more specific with that presentation.

So, I think people seeing the four-month and how impactful it is and that it was statistically significant in such a short period of time is very meaningful, and then I think when you show 12-month and show that this isn't an artifact, that that will be very meaningful. So, it's hitting the community and then following up with marketing and sales efforts to really drive it home.

Benjamin Andrew – William Blair & Company

Is there a significant spend associated with that, getting that data out, or that's just another tool in the toolbox for the sales people as they're out talking to clinics and trying to either go deep or open up additional clinics because presumably people that are already putting patients on largely believe, and this is incremental positive certainly, but it's getting that next nephrologist over the hump to start putting patients on. That's probably the big benefit from this, is that fair?

Robert S. Brown

Yes, I think you characterized it quite well in the beginning part of your question is, was there a significant expend associated. No, that's the kind of efforts that we've been doing from the start so there's no significant uptick or change in the rate of spend associated with something this opportunity.

I guess I want to come back to something I said in the past, which this three-step process of clinical data. Its one thing to say patients live longer it's a whole different thing to say not only do you live longer but you're going to live a better life too. I think a lot of clinicians have been waiting to get that answer to have the conviction to be able to look in patients eyes and say, I'm not only doing something that will extend your life, I'm doing something that will improve your life.

So, I believe it's meaningful. I think it takes time to get that kind of information penetrated into the industry but I do think, and I use certain clinicians as bellwethers, great comment on the press release from Dr. Finkelstein. He's a tough measure of this type of thing and he's very positive on that, so that's very encouraging to me, and then the third piece will be the economics to show you can't beat it. It lives longer, lives better and it's more economically viable.

So, that's the story we're headed towards, we'll bring that third piece to light in '09 and initial results there. So, I'm really excited about how this is unfolding and it's unfolding, quite honestly, at or better than I even thought it would.

Benjamin Andrew – William Blair & Company

Just thinking about the dollar spending on operating expenses is that going to stabilize of does that need to go up on a sequential basis as we go through 2009 as you think about spending expectations?

Robert S. Brown

We don't really see a significant uptick in spending next year. We think we can get quite a bit of leverage out of our spending.

Jeffrey H. Burbank

As you're seeing at all levels, you're seeing that in gross margins, so incremental patients are very leveraged for us now and you're going to see it in operating expenses as well.

Benjamin Andrew – William Blair & Company

Two last questions. I guess first have you heard any concerns from either, presumably more the independent in terms of their ability or willingness to put new clinics in as the market continues to grow so that that capital expenditures perhaps pushing people towards your therapy?

Robert S. Brown

That's an interesting comment. I have not heard that yet, that would be great, but I haven't heard it yet.

Benjamin Andrew – William Blair & Company

It's kind of the flip side of - -

Robert S. Brown

Yes, just hadn't gotten there and haven't heard it so I'll keep my ear to the ground at ASN.

Benjamin Andrew – William Blair & Company

We haven't talked about international rights for a while. Is that something sort of deep in your hip pocket for 2010, 2011 or is that something maybe we should be thinking in '09?

Robert S. Brown

I don't think I'll change your thinking at this point and when we have more clarity on that we'll come back to you and let you know.

Operator

Your next question comes from Bill Plovanic – Canaccord Adams.

William Plovanic - Canaccord Adams

I'll start out with financial questions. Just running down the P&L, it looks like the R&D was a little lighter. I mean, just trying to model forward, should we expect this spend and I know you just commented on this, but $2 million a quarter, is that what R&D is going to be at? Are we done the big spends are over or is there anything going off in the quarter that's caused that to be a little low?

Jeffrey H. Burbank

I'll take the first half and then I'll let Robert. Remember for R&D for us it's the clinical efforts and the product development efforts. So, product developments are kind of an ongoing pace spend and have been for a while and will be, clinical will be a little more choppy but I'll let Robert comment more deeply.

Robert S. Brown

Again I think that $2 million is probably a pretty good number plus or minus a couple hundred thousand dollars in the quarter primarily because of the clinical spend it comes in a little bit more choppier than the true R&D of development. That's more people based and is a little bit smoother but the clinical spend is a little bit choppier, so it will bounce around probably between the Q2, Q3 level.

William Plovanic - Canaccord Adams

To switch on the running through the P&L, on the fair value financial instrument, it's 3,100 do you get a continued benefit when you surpass 3,100 patients or is that the number that was your starting point as you went up and down every quarter, and I know that the final value is based on that but the intermediate valuation swings are based on volatility and stock price and all that.

Robert S. Brown

The range is 3,100 to 3,500 and if it's below 3,100, the strike price resets to $3, if it's above 3,500, it would set to $6.50. It's really pretty much a digital event at the end of the year, but that's not what's been driving these adjustments. It's all been Black-Scholes on the –

Robert S. Brown

Stock price and volatility, and I just want to make sure we're clear on that.

William Plovanic - Canaccord Adams

So, but when you initially price the instruments, if it's somewhere between 3,100 and 3,500 is it set at, I forget, what is five bucks or whatever that conversion price was, four and change.

Robert S. Brown

Yes, it's set at $5.50 the strike price.

William Plovanic - Canaccord Adams

It's set at five, so if it's anywhere between 3,100 and 3,500 its $5.50 is the strike price. Is that correct?

Robert S. Brown

It stays where it's at, right.

Jeffrey H. Burbank

That's correct.

William Plovanic - Canaccord Adams

If under 3,100 it's $3.00, over 3,500 it's $6.50, so at this point if you're over 3,000 and we've got 60 days left, pretty good chance you're going to hit that 3,100, at least you're trying damn hard to hit it, is that fair to say?

Robert S. Brown

That's fair to say, we're working hard to.

William Plovanic - Canaccord Adams

Just to switch to clinical data, the FREEDOM data was solid. I think we had pulled out another study relative to renal recovery, we didn't hear anything about that on this call, just your initial response to seeing that level of data and what your thoughts are there.

Robert S. Brown

You're referring to the abstract from Krause that talked about six of his patients recovering renal function.

William Plovanic - Canaccord Adams

Yes.

Robert S. Brown

Yes, I think we have to be very careful and not read too much into it. So, everybody has a slightly different mix of patients due to the access of where they are. So, he may be having some types of patients that are more susceptible to that. So, I'd be very cautious in our conclusion that that could be replicated or broadly demonstrated. However, I do think it's a nice example that in some way again supports the quality of therapy.

Now I don't think it's to the extent that we're going to take people off of therapy, but I do think it shows that the therapy is a good therapy that allows for some of those things to happen. So, it's cautious but I think it's more just here's another example that leads you to the conclusion that this is a good therapy, clinically very successful.

William Plovanic - Canaccord Adams

To switch back on your go-deep strategy, is there any other efforts you've been doing lately? Is it increasing the spend, does it just keep going back to the same facilities? I think you said that the spend wouldn't go up. Are you putting more reps at each center, remind us what exactly you're doing relative to what you are you doing differently versus what you were doing before?

Robert S. Brown

Well, first is by focusing on the centers we have we are able to allocate more sales and support time to those centers versus starting new centers, and we find a better return on investment in doing that. So what are we doing with them?

We're continuing to market the data that exists and get the word out and talk to the referring physicians, we're doing patient education activities, which expose patients that may be in-center or on other therapies to the process as well as the outcomes of daily home therapy. We're working with centers to effectively see and develop what their marketing programs are in their communities and we're also working to make sure they have the most efficient and effective training programs in process.

So it's a number of activities that comes out of the partnering and a focus from both parties on doing this right. It's not increasing our spend there, it's a more efficient spend of what we were and a better allocation of resources to building this business in a sustainable economic way.

William Plovanic - Canaccord Adams

A couple of quarters ago we talked about DaVita kind of taking a look again at the home therapy market and how to best attack or approach that relative to some of the centers that were doing better than others. What was the net outcome of that, it's been six, nine months, we should have in your discussions with DaVita, what have they said, kind of an update on those conversations?

Robert S. Brown

DaVita’s working really hard on this. They continue to grow patients. They continue to add to patients. All that said, we think there’s a lot of upside in this market and we’re focused on working with them and all of our providers to figure out the best way to go at that and bring that opportunity home. So, I’d say they’ve done a lot of things and have worked really hard on the behalf of home hemodialysis.

William Plovanic - Canaccord Adams

Is there anything specific you can point to or anything they changed in any of their programs? I mean, if you’re going to analyze something and look that long and deep and hard into it, you’re going to come out with some, a plan of action. Are there any changes that you can just share with us?

Robert S. Brown

I think we’ve all, if we’re watching very closely, we’ve all seen some changes in terms of marketing dollars spent and local programs. DaVita continues to invest in those types of things to see what the effectiveness is and our experience has been that things that bring patients in contact with patients that do the therapy can be very effective and things that get the word out from a patient or a patient and clinician into community and we saw them do some things in Arizona where they were actually on a TV show doing things like that.

So, they continue to try to do some things that we’re all watching to see how effective they are and how cost effective they are. That get to you what you’re looking for?

William Plovanic - Canaccord Adams

Yes, that is, and then relative to PureFlow what was the penetration rate this quarter?

Robert S. Brown

We’re approaching 75%.

William Plovanic - Canaccord Adams

[inaudible] it's 50 some odd million between cash and available line of credit. When, roughly, do you expect to get cash flow positive in the business?

Robert S. Brown

Well, we haven’t been specific on the date, but again, I think we direct you back to the adjusted EBITDA number, as you watch what we’re doing here and it’s really declining that number. So, basically, as we grow revenues, as gross margins improve that adjusted EBITDA number actually shrinks, the loss shrinks there, and then as Jeff mentioned earlier we have quite a bit of equipment still on hand so we won’t be spending a lot of cash on the equipment for a few quarters so that actually helps us move in that direction too.

William Plovanic - Canaccord Adams

As I’m modeling this out and everybody else is taking a look at this, is this a 2010 event when you become cash flow positive, a late 2009 event? What is it in your opinion or in your model?

Jeffrey H. Burbank

We’re not going to be that specific. We’ll focus on the things that grow a sustainable, successful business, and we’ll come back to you as we get visibility and our plans are locked in.

Operator

Your next question comes from Philip Legendy – Thomas Weisel Partners.

Philip Legendy – Thomas Weisel Partners

First, there was a comment in the prepared remarks. Did you say that patients trained are up 24% from last quarter? Was that correct?

Jeffrey H. Bank

No, let me clarify. The training rate of centers is up 24% over last year.

Philip Legendy – Thomas Weisel Partners

I wonder if you’d comment on how pricing has been doing in the home segment. It looked like it might be down a bit. I wonder if that’s just my math playing some games.

Robert S. Brown

Yes, on the last call we actually mentioned that we did take some price increases in Q2 but it’s been relatively stable form there on. When you do your math a lot of it depends on when you put patients on in a quarter, whether patients come evenly throughout the quarter, whether they come on at the end of the quarter or the beginning of the quarter. So, you will get swings from quarter to quarter in your ASP calculations.

Philip Legendy – Thomas Weisel Partners

Also, on how many patients are coming on in the quarter, but, my numbers are no longer as good there.

Robert S. Brown

Pricing’s been stable.

Jeffrey H. Bank

Pricing’s been stable, revenue’s been growing, gross margins are improving. You know the drill sustainable business.

Philip Legendy – Thomas Weisel Partners

That’s helpful. I just want to eliminate that variable. Then the last one I had here was I wonder if you could give us an idea of whether you’re seeing an improvement in the patient attrition rates as you rollout some of the updates that you have to make those water-testing requirements a bit easier for patients.

Jeffrey H. Burbank

Yes, let me go back a little and then project forward. Obviously that was one of the things we pointed to in Q1 that was one of our challenges in that timeframe. After Q2, I said it was encouraging. We were back to more traditional levels, but I wanted to watch it to make sure. We’ve now watched it another quarter and they continue to remain at levels that we’re pleased with and so they have been to traditional retention rates or improving slightly. So, we feel good about that.

Philip Legendy – Thomas Weisel Partners

So, it sounds like what you’re saying is you’ve seen an impact from the rollout and, not only that but you’ve kind of seen what you expect to see. You don’t expect to see any more changes from here.

Jeffrey H. Burbank

No, long-term we’ve talked about opportunities in going deep and product that could impact that. That will take multiple quarters. Short-term we had the issue that we addressed with water testing that was shaking some patients off that we think we’ve address.

Kristen Sheppard

Operator, I believe this is our last question if we have one, please.

Operator

No we don’t.

Robert S. Brown

Well, thank you everyone we appreciate you joining the call and we look forward to sharing our results of the fourth quarter.

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Source: NxStage Medical Inc. Q3 2008 Earnings Call Transcript
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